When switching from ASC 605 to the new revenue recognition standards (ASC Topic 606 or IFRS 15), do you believe the switch only affects revenue? Many believe this to be true, which is not unreasonable given the new standards are titled Revenue from Contracts with Customers. However, these new, principles-based accounting standards also introduce guidance that will directly impact many areas of financial reporting, not just when and how companies record revenue. And these might lead to differences in your current accounting practices. Let’s take a look at some of the non-revenue impacts of the new standards.
Historically, there have been discrepancies in practice when it comes to accounting for the costs associated with revenue contracts. For example, previous IFRS did not provide any specific guidance for the treatment of contract acquisition costs. But under U.S. GAAP, the SEC did provide guidance in this area allowing companies to elect to capitalize certain costs incurred in the acquisition of different contracts. To resolve these differences, the new standards include guidance on the accounting for costs associated with acquiring and fulfilling revenue contracts.
While the new standards do not replace the majority of cost guidance in other standards (such as inventory costs), they do require companies to capitalize the following types of costs, as long as the expectation is that they will be recovered:
- Contract acquisition costs. Capitalize any incremental cost of contract acquisition.
- Contract fulfillment costs. Capitalize any direct costs that generate or enhance a company’s resources to be used in satisfying future performance obligations. This guidance includes costs associated with “anticipated” contracts, so companies will have to determine how they view this threshold when accounting for such costs.
Once these costs are capitalized, they are amortized as the related good or service is transferred to the customer. Similar to any asset, companies will also need to evaluate such capitalized costs for impairment. However, the impairment model to apply is different than the current asset impairment models in IFRS and U.S. GAAP, so it’s important to keep this in mind, particularly when dealing with impairment of a cash-generating unit (IFRS) or an asset group (U.S. GAAP).
So what types of costs might be capitalized? Well, it depends on their nature but some possible capitalizable costs are:
- Direct labor and materials
- Bid costs
- Sales commissions
- Subcontractor costs
- Directly related depreciation or amortization
- Other costs chargeable to the customer under the contract
What costs aren’t capitalized? Most general and administrative costs will be expensed as incurred, as well as the costs of wasted materials, labor, and other resources that were not considered as part of the original contract.
How might this impact you?
Companies might currently be expensing costs that are required to be capitalized under the new standards. Also, if they execute a significant amount of contracts, identifying and tracking all of the costs to be capitalized may prove to be somewhat difficult, particularly if they are dealing with rather antiquated or manual accounting systems. Does your company pay commissions? Again, distinguishing the direct and incremental components of such agreements can be challenging and may require judgment.
Check out this post regarding the SEC's view of costs associated with pre-production arrangements.
Sale of Non-Financial Assets
Does your company sell real estate, but not on an ongoing basis? What about sales of property, plant and equipment? The new standards provide guidance for the sale or transfer of non-financial assets outside of a company’s ordinary business activities (such as the sale of real estate, property, plant, and equipment, or intangible assets). These transactions are not presented as revenue, but are separately recognized as gains or losses in the financial statements. When accounting for such sales, companies must apply the recognition and measurement guidance of the 5-step model outlined in the standards. Therefore, the timing of de-recognition, as well as the recognition and measurement of any gains or losses, will be impacted by applying the guidance in the new standards.
How might this impact you?
It depends. Under current guidance (such as IFRS), you might be recognizing sales of non-financial assets when the risks and rewards of ownership transfer to the purchaser. Given that the new standard requires recognition upon the transfer of control, this may lead to differences in the recognition timing of any gains or losses. Additionally, in certain instances, you may be determining the gain or loss on disposal based on the fair value of the transferred asset; the new standard requires companies to use the transaction price as determined in Step 3 of the new model, possibly resulting in a different gain or loss.
Do you provide financing to the purchaser in such arrangements? If so, you will need to consider collectability when applying Step 1 of the new model and may result in difficulty establishing that a contract exists.
What about U.S. GAAP? Are you currently subject to the sales of real estate guidance in U.S. GAAP? If so, the new standard will be significantly different than the current guidance you are applying, particularly given the strict criteria for full profit recognition provided for in ASC Topic 360.
Check out this explainer video that we created to help you with the application of ASU 2017-05 related to the derecognition of non-financial assets.
Another area that will be significantly impacted by the issuance of the new standards is income taxes. Why? The biggest reason is the potential for additional differences between financial reporting and tax reporting, resulting in an increase in the number of temporary differences.
Given the potential significant impact (and cost) on companies adopting the new standards and accounting for income taxes, taxing authorities are also busy trying to understand the impact of the new standards. For example, the U.S. Internal Revenue Service (IRS) issued a notice in June 2015 asking for comments on the perceived book/tax impacts of applying the new 5-step model. In the notice, the IRS identified a variety of areas that may be impacted when applying the new standards. These areas include:
- Recognizing income for tax purposes under the percentage-of-completion method
- Providing services
- Entering into bill-and-hold transactions
- Determining impact when accounting for sales returns and warranties
How might this impact you?
Well, that answer depends on the company’s specific tax situation, their tax jurisdictions, and the laws and regulations. In the U.S., the Internal Revenue Code generally requires taxpayers to compute taxable income under the same method of accounting they use to compute book income. Currently, most companies recognize income when the right to receive income is fixed and the amount can be determined with reasonable accuracy (using what is called an “all events test”).
The question the IRS is currently analyzing is whether the new 5-step model provides a permissible method of income recognition for tax purposes. If not, this will result in increased temporary differences and requirements for companies to track this information for proper financial reporting and tax-return filing.
Regardless of jurisdictions, it is important for companies to analyze the regulations governing income recognition for tax purposes and how that compares to the revenue recognition guidance in the standards. This analysis may identify the following impacts:
- Changes in the amount or timing of recognition of revenue and/or expenses for book purposes, which may result in changes to the recognition of income or expenses for tax purposes
- Changes to existing temporary differences or the creation of new temporary differences due to differences in revenue or expense recognition for book purposes compared to how such items are recognized for tax purposes
- Updates and revisions to transfer pricing arrangements and other tax strategies
- Impacts to foreign earnings and additional considerations to take into account when asserting “indefinite reinvestment” pursuant to APB 23 (this area has been a significant area of focus lately as discussed in our blog “Ask the fortune teller: Considering a repatriation of funds?”)
- Updates to an organization’s internal controls, processes, systems and policies related to income tax accounting
- Changes to sales or excise taxes due to recharacterization of revenue compared to current treatment
Under the new standards, companies must evaluate the different types of warranties they provide separately or offer with their products in order to determine the accounting impact. Service-type warranties represent a distinct service and are to be treated as separate performance obligations. However, assurance-type warranties are not treated as separate obligations, but evaluated as warranty obligations utilizing existing guidance.
What’s the difference?
Well, if a customer has the option to purchase a warranty separately (such as an extended warranty) or if the warranty provides protection beyond fixing any defects that existed at the time of sale, the entity is providing a service-type warranty. Assurance-type warranties, on the other hand, are effectively guarantees of quality (i.e. the product will function as advertised).
How might this impact you?
Have you ever dealt with a transaction with a warranty provision that led to you deferring revenue? This may be the case if you follow IFRS, as IAS 18 required the consideration of warranty provisions when evaluating whether or not the risks and rewards of ownership transferred from the seller to the buyer. This would not be the case under the new revenue recognition standards and companies would consider the guidance outlined above to determine the impact of warranty obligations on their revenue contracts.
Additionally, companies may find themselves identifying more warranty arrangements as separate performance obligations (i.e. service-type warranties) than compared to current guidance. For example, under existing U.S. GAAP, only separately priced warranties are identified as separate deliverables (i.e. units of account), which is different than the guidance within the new standards.
Lastly, for warranties representing separate performance obligations, the amount of revenue allocated to the warranty might differ from current practice, particularly if you apply U.S. GAAP, which requires companies to defer the contractually stated amount of the warranty.
Check out this post on the accounting for warranties under ASC 606.
Sales Returns and Allowances
How do you currently recognize sales returns and allowances? Do you present them net in the financial statements? If so, applying the guidance in the new standards will be different than current guidance and impacts accounts outside of just revenue. Under IFRS 15 and ASC Topic 606, companies are required to consider their estimates of returns as part of determining the transaction price (Step 3), which is relatively similar to current practice. However, the expected returns will be recognized as a separate refund liability and the right to recover the related goods from your customers will be recognized as a separate recovery asset (with an offset to cost of sales). Subsequent to the initial recognition of these amounts, the refund liability and recovery asset will be updated for any estimated changes.
How might this impact you?
Under the new standards, entities may change their estimation methods in determining the impact of return rights on their transaction price (as part of Step 3 of the new model) but the method will generally be consistent with current practice (and have a similar income statement impact). However, as discussed above, the net method of presentation will no longer be allowed for sales returns and allowance and, therefore, will impact companies’ balance sheets.
The new revenue recognition standards may have significant impacts throughout your organization. We’ve looked at some of the other (i.e. non-revenue) direct financial statement impacts above, but haven’t even begun to discuss the indirect impacts. These are more far-reaching and range from internal controls, processes and systems to impacting the structure of employment agreements and other contracts that are in some way impacted by the adoption of the new standards (such as loan covenants). We’ll save these topics for a future blog post, but just remember that even though IFRS 15 and ASC Topic 606 are new revenue standards, the breadth of their impact is much greater than just this single financial statement line item.
And lastly, remember that you are not alone in navigating the maze of requirements within the new standards. GAAP Dynamics has published a series of posts walking you through each step of the new 5-step model. Whether from a training standpoint or from an advisory perspective, we’re here to help! Please contact us to discuss your specific needs.